Adverse selection - week 5 Flashcards
Asymmetric information definition
Asymmetric information: Situation in which a buyer and a seller possess different information about a transaction.
Seller - Buyer
Employer - Employee
Firm manager - Firm owner
What is adverse selection in the context of asymmetric information?
Adverse selection is a form of market failure that occurs when products of different qualities are sold at a single price due to asymmetric information. This leads to too much low-quality product and too little high-quality product being sold.
(Adverse selection happens when people don’t know the real quality of a product or service, so bad-quality things end up dominating the market.)
What is moral hazard in the context of asymmetric information?
Moral hazard occurs when a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event.
(Moral hazard happens when one person’s risky behavior is hidden from others and affects them.
Example: Someone with car insurance might drive recklessly because they know the insurance company will pay if something goes wrong. The person’s risky behavior creates costs for others (like the insurer).
What are some scenarios of adverse selection?
- Buying second hand (uncertain about product quality)
- Employing a new worker (uncertain about worker’s productivity and drive)
- Buying health insurance (unsure if the person is going to be healthy or unhealthy)
- Credit market (unsure if the person is a low-risk or high-risk borrower)
What is adverse selection in second-hand markets, and how does it affect prices and sales?
Adverse selection happens when sellers know more about the quality of goods than buyers, leading to an imbalance in the market. For example, in the second-hand car market:
Asymmetric information: Sellers know if their car is a “lemon” (low quality) or a “peach” (high quality), but buyers don’t.
Buyer uncertainty: Buyers can’t tell the difference, so they assume a higher risk and are only willing to pay lower prices.
Market impact: High-quality cars (“peaches”) are driven out of the market because sellers can’t get fair prices. This leaves mostly low-quality cars (“lemons”), reducing the number of cars sold and lowering overall prices.
: How does adverse selection affect second-hand car markets? (money example)
In a market with two types of cars:
Peaches (good cars): Worth £6000.
Lemons (bad cars): Worth £2000.
Buyers can’t tell if a car is a peach or a lemon, so they offer the average price of £4000.
What happens at a £4000 price?
Sellers of peaches won’t sell because £4000 is too low for a car worth £6000.
Sellers of lemons will sell because £4000 is higher than the car’s value (£2000).
Result:
Only lemons are sold, and peaches leave the market. This is called adverse selection, where bad-quality products drive out good-quality ones.
Over time, buyers lower their offers further, and the market might collapse.
This leads to inefficient outcome - the best cars (peaches) are unsold even though there are prospective buyers and sellers.
How does market signalling solve adverse selection?
Market signalling is when the informed party sends credible information to the uninformed party to reduce the information gap.
How it works:
Signals must be credible for the recipient to trust them.
Examples: A university degree signals to the employer that an employee is qualified. A warranty helps signal to buyers a car’s quality.
Adverse selection in job hiring
Adverse selection problems can arise for employers in the hiring process:
- Asymmetric information about worker type (low and high ability)
- Can impact productivity of the firm
Adverse selection problems can also arise for prospective employees.
- They may have less information about working conditions than firms do
What is the difference between weak and strong signals in market signalling, and how does this solve adverse selection?
Weak signals:
Do not clearly distinguish high-productivity individuals from low-productivity ones.
Example: In the labour market, a weak signal might not help firms identify the best workers.
Strong signals:
Must be easier for high-productivity individuals to provide than for low-productivity ones.
Example: Education – More productive people are likely to achieve higher education levels, which signals their productivity to firms and helps them secure better-paying jobs.
Why it works:
Strong signals allow high-quality individuals or products to stand out, reducing the problem of adverse selection.
How does adverse selection affect hiring, and how is wage determined?
Profit Maximization Rule:
Employers maximize profit when MC = MR.
Wage (w) is set equal to the Marginal Revenue Product (MRP) of workers.
Implications of Wage (w) vs. MRP:
If w>MRP: Employer makes losses.
If w<MRP: Workers know their productivity and leave for better-paying jobs.
Key Point:
If all workers have the same productivity, the employer can pay a wage equal to their MRP to avoid adverse selection.
Creating a job contract under perfect information vs asymmetric information
Perfect information:
- Employer wants to hire workers but knows that some workers are of higher quality i.e., they will be more productive
- Employer prefers to hire the high productivity types
- The problem for the employer is to devise a wage contract that doesn’t make a loss and attracts the high productivity type workers
Asymmetric information:
- Employer cannot tell which workers are higher quality
- Employer is not able to prepare an appropriate contract
What are the solutions for adverse selection in product markets?
To address adverse selection, buyers (principals) must gain more information, or sellers (agents) must provide credible signals of quality:
Inspections by experts: Independent evaluations of products.
Legal requirements: Product liability laws incentivize sellers to offer safe products.
Compliance with sanctions: Social norms and honesty in small communities.
Reputation: Built over time through reliable performance.
Signalling with guarantees/warranties:
Guarantees/warranties serve as credible signals.
Simple claims without proof are considered “cheap talk.”
Signalling with a guarantee
-Guarantees (warrantees) need to be valued by buyers
-Providing a guarantee should carry an expected cost
- The expected cost needs to be higher for low quality cars (lemons) as the car is more likely to have faults or need fixing. - May not be worthwhile offering the guarantee or only worth offering a shorter guarantee
- In either case, buyers can differentiate so buyers pay more if there is a guarantee or a longer guarantee
What are the conditions for guarantees to mitigate adverse selection in markets?
Using guarantees as signals
Assume consumers perceive any good with a guarantee (G) to be a high-quality good - pay PH
- For this to work the guarantee has to be send by the high quality producer only - but can this happen?
- Only if the guarantee is worthwhile for the high quality producer but not worthwhile for the low quality producer
How do guarantees work to separate high-quality from low-quality sellers? maths :(
High-quality sellers offer guarantees if:
PH - CH - GH > PL - CH
(The extra money from a higher price covers the guarantee cost)
Low-quality sellers won’t offer guarantees if:
PL - CL - GL < PL - CL
(Guarantees are too expensive, so they don;t bother)
Why this works:
- Good sellers can afford them, showing they’re legit
- Bad sellers can’t fake it because its too costly
This helps buyers trust products with guarantees
Therefore higher quality products can sell for a higher price than low quality products with a guarantee
